How Taxes Affect The Economy

The last few years have been chock-full of heated discussions about what should be done to solve the ballooning U.S. debt problem. On one side are those who believe higher tax rates are needed to bring in desperately needed revenue. On the other side are those who believe that raising taxes is a bad idea during a recession, and that lower rates will actually increase revenues by stimulating the economy. To gain some historical perspective, here's a look at some of the key tax policies that have made headlines over the past three decades.

ReaganomicsWhen he ran for president in 1980, Ronald Reagan blamed the nation's economic ills on big government and oppressive taxes. He said that the way to promote economic growth was to gradually reduce taxes by 30% over the first three years, concentrating most of it in the higher income brackets. It was known as "supply-side" or "trickle-down" economics, but the media dubbed it "Reaganomics." (To learn more, check out Understanding Supply-Side Economics.)

The theory was that upper income taxpayers would then spend more and invest in businesses to drive economic expansion and job growth. Reagan also believed that over time, lower rates would translate into higher revenue, because more jobs meant more taxpayers. He essentially put into practice the economic theories of Arthur Laffer, who summarized the hypothesis in a graph known as the "Laffer Curve." Congress hedged its bet by agreeing to a 25% overall rate cut in late 1981, and later indexed rates for inflation in 1985.

Initially, inflation was reignited and the Federal Reserve hiked interest rates. This caused a recession that lasted for about two years, but once inflation was brought under control, the economy began to grow rapidly and 21 million jobs were created during Reagan's two terms.

Reagan wanted to offset increased defense spending with reductions to entitlement programs, but that never happened. As a result, the national debt nearly tripled during his two terms, from $900 million to $2.7 trillion. So while tax revenues and GDP both rose an average of 7% per year under Reagan, it's impossible to determine how much of that growth was due to tax cuts versus deficit spending.

Clinton YearsBill Clinton's tax policies provided insight into the impact of both tax increases and decreases. The Omnibus Budget Reconciliation Act was passed in 1993 and it included a series of tax increases. It hiked the top income tax rate to 36%, with an additional surcharge of 10% for the highest earners. It removed the income cap on Medicare taxes, phased out certain itemized deductions and exemptions, increased the taxable amount of Social Security and raised the corporate rate to 35%.

During the next four years, the economy added 11.6 million jobs, but average hourly wages grew only 5 cents per hour. The stock market went on a bull run, as the S&P 500 index rose 78% after adjusting for inflation.

When the Newt Gingrich-led Republicans wrested control of the House of Representatives in 1994, they ran on a platform known as the Contract with America. The provisions included commitments to reduce taxes, shrink the federal government and reform the welfare system. By 1997, unemployment had dropped to 5.3% and the Republicans passed the Taxpayer Relief Act. Clinton resisted the bill at first, but ultimately signed it.

This act reduced the top capital gains rate from 28 to 20%, instituted a $500 child tax credit, exempted a married couple from $500,000 of capital gains on the sale of a primary residence, and raised the estate tax exemption from $600,000 to $1 million. It also created Roth IRAs and education IRAs and raised the income limits for deductible IRAs.

During Clinton's first term after the tax increases, revenues rose 7.4% per year, GDP rose 5.6% per year, and the national debt increased $730 billion. During his second term after the tax cuts, revenues rose 8.7% per year, GDP rose 5.7% per year, and the debt was reduced by $409 billion. While the data supports the contention that tax cuts were better medicine for the economy, the second term had the benefit of the technology boom that produced the computer and internet revolutions. Many of the high-tech jobs created by that boom were lost when the Nasdaq cratered after Clinton left office, bottoming out in Oct. 2002.

The Bottom lineOne interesting data point is the relative stability of the ratio of tax revenue to GDP, regardless of the existing tax policies over time. During the period 1981 to 2000, which encompassed both Reagan and Clinton, that ratio hit a low of 15.8% and a high of 19.9%, with an average of 17.5%. This indicates that the best way to jump-start revenues is to grow the economy through stimulative tax policies. (For more, read A Concise History Of Changes In U.S. Tax Law.)

Barack Obama has consistently pushed for higher taxes on the "rich" to help reduce the deficit, but the debate continues on whether or not higher rates actually result in more tax revenues. The problem is that changes in tax rates can't be analyzed in a static environment, but that's how most politicians view these changes. The fact is that changes in rates alter behavior and most taxpayers will do whatever it takes to minimize their tax burden.